Employers’ surpluses or members’ reserves?

Many employees who have transferred from traditional defined benefit pension funds to defined contribution provident funds are totally unaware that they have left behind huge portions of assets previously reserved for them. The South African pensions industry is currently arguing over who owns the 80bn rand surpluses (£7.2bn £1 to 11.16 rand) that have recently emerged in private pension funds. But little attention is being given to what actually constitutes a pension fund surplus and how it originated.

Members’ reserve value lost on transfer Under British law, much of this 80bn rand ‘surplus’ would not be recorded as surplus. In South Africa, however, what may be called reserves one day can easily be converted to surpluses the next day. Lack of governance in South Africa allows reserves to be stripped out of members’ benefits on transfer. In many pension funds, up to 40% of members’ and pensioners’ reserves have been converted to so-called surpluses. Union representatives are angry at the discovery that what they perceived to be their members’ full value in some pension funds being transferred to provident funds has in fact been only a portion of the original funds set aside for their members. The Chemical Workers Union recently learnt that nearly 40% of assets set aside for union members was left behind in the Sentrachem pension fund when their members transferred to a provident fund. The Chemical Workers Union, with the support of Swedish Social Responsibility money, will be funding a test case on this issue in the High Court.

Murphy’s Law Pension funds adjudicator, Professor John Murphy, recently supported the South African practice of declaring investment reserves as surplus. In a decision that goes directly against British practice, Murphy defines the South African pension fund surplus as the difference between the market value of the assets of the fund, and the value of the liabilities. In British actuarial practice, a surplus is clearly defined as the difference between the actuarial value placed on the assets and the liabilities of the fund. This subtle difference in terminology makes a huge difference in the value of funds transferred for employees and pensioners. Depending on the stockmarket, this difference could be up to 40% of the value of the actuarial reserve. In a transfer from one fund to another, British law requires the transfer value to take into account the market value of the assets. According to Murphy, South African practice only need take into account the notional value placed on the assets by the actuary. The issue is that for members transferring from one fund to another, nearly half of the reserve value is often left behind in the original fund and converted to surplus. The impact of this loss to employees over the span of their working career will be devastating.

Current practice The South African Actuarial Society appears content with the arrangement, as does the Financial Services Appeal Board. Now companies are rushing to liquidate their pension funds in order to realise profits worth over 80bn rand. The Sentrachem Group Pension Fund is an excellent example of how surpluses were realised after transferring out members and pensioners. In 1995 the 650m rand fund had a 57m rand shortfall in budgeted investment returns. By 1998 the fund had achieved a surplus of over 400m rand after transferring out most of its members and pensioners. In 1999 pensioners were only granted a 1.4% increase. There are currently 300 of the original 6,000 fund members left. According to chief actuary of the Financial Services Board, Jeremy Andrew, this pension fund appeared to have operated well within the bounds of acceptable actuarial practice.

Profits subsidised by pensioners Another practice of using inflation to create surpluses in pension funds has a devastating impact on both the lives of pensioners and on the economy of the country. For years, many pension funds have granted pension increases below the rate of inflation. By doing this in a fund that can afford to grant full inflation increases, a surplus is created. In more recent years, some actuaries have taken this pension devaluing practice one step further. Instead of creating a surplus slowly each year by allowing inflation to devalue to the purchasing power of pensions, the actuary has reduced the total amount of assets set aside to fund pensions. This has happened particularly when transferring pensioners out of traditional pension funds to institutions like Old Mutual or Sanlam. When transferring the pensioners’ reserve value, the investment reserve portion of the total actuarial reserve is left behind. This in turn creates a massive surplus in the fund. In 1999 many pensioners only received token annual increases of around 1% because of the previous year’s crash on the stockmarket. However, had the investment reserve portion of the total actuarial reserves been transferred with the pensioners, the institutions would have been able to grant full inflation increases, despite the crash. This means that struggling pensioners are spending less money in the economy, while huge surpluses in pension funds are awaiting transfer to the employer companies. Many of these companies are likely to move these windfall profits overseas. A recent decision by the Financial Services Pensions Appeal Board allows surpluses created by these means to be repatriated to or simply paid to the employers.

Conflict of interest Are executives of companies who are trustees of pension funds benefiting personally from converting pension fund investment reserves into surpluses? If the executive is a shareholder of the company, or has share options, then by agreeing to the actuary converting reserves initially set aside for fund members’ benefits into surpluses, the executive is likely to benefit substantially. Increased profits from a company absorbing huge pension surpluses could result in many executives benefiting by more than 1m rand each. While 80bn rand is about to be paid to companies, it is strange that nobody is complaining about possible conflict of interest on the part of trustees who may benefiting through increased profits of the company as a result of artificially created surpluses! Before so-called surpluses are paid to companies, members must be sure that the surpluses have not been created by devaluing members’ and pensioners’ actuarial reserves. Trustees of pension funds who hold company share options must ensure that their agreement to convert members’ reserves to surpluses is not subject to conflict of interest charges. Trustees have a fiduciary obligation to look after the best interests of their pension fund members over their own personal financial interests. What is an investment reserve? Stockmarket value of shares fluctuate from day to day. Actuaries normally place a lower value on shares than the market value. This ensures that when the share market drops to more realistic values, there are still enough funds set aside to fund pensions. The difference between the actuarial value of the assets and the market value of assets is called an investment reserve. South African actuaries started calling this investment reserve a ‘market value surplus’. On transfer out of the fund, this reserve, with its new title ‘surplus’, has been lumped together with the actuarial or real surplus. However, if members and pensioners remain in the fund, this surplus or reserve (regardless of what it is called), forms part of the total assets reserved to fund the liabilities of the fund. This value is included in the funding requirements as reported to the Financial Services Board in the valuation reports.